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Although state tax revenues have begun to rise again, the
severe fiscal problems of the past several years continue to dominate the
budget landscape. This paper very briefly discusses key aspects of the fiscal
crisis and the outlook for 2005 and beyond; more detailed information can be
found in the reports cited at the start of each section.

Following eight consecutive quarters of declines, state
revenue growth returned to relatively normal levels in fiscal year 2004.
As a result, there was less need for mid-year budget cuts during fiscal year
2004 in most states than in the previous two years.

However, many states  including Alaska, California,
Illinois, Louisiana, Nebraska, New Jersey, and New York  faced large budget
shortfalls for fiscal year 2005. In 30 states where shortfalls were
identified, the amounts reached levels of $35 billion to $40 billion, or about
7 percent to 8 percent of those states expenditures. As a result, many
states continued to enact cuts in spending, revenue increases, new borrowing,
and/or reserve-fund transfers for fiscal year 2005. Several states,
including California, Maryland and Wisconsin, already are projecting large
deficits in 2006 and beyond.

The 2005 deficit amounts were on top of the estimated
$78 billion shortfall that states faced when they enacted their fiscal year
2004 budgets, as well as large deficits that were addressed in fiscal years
2002 and 2003. The National Conference of State Legislatures estimates
that over the last four years, states have had to close a cumulative budget
gap exceeding $200 billion.

During the fiscal crisis, states have closed budget gaps
more by cutting spending than by raising taxes. Indeed, spending cuts
have been three times as large as tax increases. As a result of these
spending cuts, total state spending has shrunk significantly since 2001 as a
share of the economy. In FY 2004, spending was 4.6 percent of the Gross
Domestic Product (GDP), the lowest level in almost 15 years and well below the
level to which it dropped during the economic downturn of the early 1990s.
State spending is projected to decline still further as a share of GDP in
2005.

States have made cuts in a wide range of programs,
including:

Some 34 states have cut eligibility for public health
insurance. The Center estimates that these cuts have caused 1.2 million
to 1.6 million low-income people  including 490,000 to 650,000 children and
large numbers of parents, seniors, and people with disabilities  to lose
publicly funded health coverage.[3]
Although some modest restorations have occurred, the great majority of those
people remain without coverage, and major additional cuts are planned in
Mississippi and Tennessee.

At least 23 states have cut eligibility for child care
subsidies or otherwise limited access to child care.In about half the states, low-income families who are eligible for and
need child care assistance are either not allowed to apply or are placed on a
waiting list. More than 280,000 children are on waiting lists in California
alone.

Real per-pupil aid to school districts for K-12 education
declined in 34 states between 2002 and 2004. Effects of the cuts
include new or higher fees for textbooks and courses, shorter school days,
reduced personnel, and reduced transportation.

States across the country are cutting higher education,
leading to double- digit increases in college and university tuition and
reduced course offerings. In 2005, funding shortfalls for higher education
are requiring tuition increases or service reductions in California, Maine,
Maryland, Massachusetts, and Texas.

Cutbacks also are occurring in
various other areas, such as state aid to localities, substance abuse
treatment, programs for the mentally ill, and homeless shelters.

The main cause of the state fiscal crisis is flagging state
revenues. Total state tax collections for the 12 months ending in June
2003 (the period that corresponds to fiscal year 2003 in most states) were
about $21.6 billion less, in nominal terms, than for the 12-month period
ending in June 2001, according to the U.S. Census Bureau. When adjusted
to compensate for inflation and population growth, revenues in this 12-month
period were $56.9 billion less than in 2001. Revenue growth in fiscal
year 2004 only partially closed this gap.

State taxes now make up a smaller share of the economy than
at any time in the last thirty years, with the exception of the double-dip
recession of the early 1980s.

The decline in state revenue
would have been even worse had not a majority of states raised taxes. Since
late 2001, about 31 states have expanded their tax bases or increased tax
rates to lessen the decline in revenues. Such tax increases have been enacted
in states with Republican leadership, Democratic leadership, and bipartisan
leadership. These net tax increases are raising some $20.2 billion annually,
about 3.6 percent of total state tax collections.

Nevertheless, the tax increases
enacted during this downturn are far fewer and smaller than the tax cuts
enacted during the economic expansion of the 1990s. From 1994 to 2001, some
44 states enacted significant tax cuts. The economic boom of the late 1990s,
and in particular the large increase in capital gains during those years,
temporarily offset the revenue loss resulting from those tax cuts. Those
temporary economic conditions have ended. Yet most of the tax cuts of the
1990s remain in place and are costing states some $40 billion or more per
year.

It
also is worth noting that while most of the tax cuts of the 1990s were in
progressive taxes (taxes that fall most heavily on higher-income
households), most of the recent tax increases have been in regressive
taxes. In other words, lower-income households benefited less from the tax
cuts of the 1990s and now are being hurt more by the tax hikes of 2001-2004.

States revenue problems are
likely to persist even after the economy fully recovers. In coming years,
state costs will increase for such services as education, corrections, and
health care (the last a reflection of the ageing of the population). In most
states, though, tax revenues are not expected to keep pace with those costs
because of widely recognized flaws in state tax systems. These flaws include
an inability to tax Internet purchases fully, excessive reliance on excise-tax
revenues, expanded use of tax loopholes by corporations, and a failure to
apply sales taxes to most purchases of services, which are becoming an
increasing share of all economic activity.

In 2002, 2003 and 2004, some
states strengthened their tax systems in ways that will help address both
their immediate and longer-term revenue problems, such as increasing income
tax rates, closing corporate tax loopholes, and broadening sales tax bases to
include more services. A larger number of states, however, raised revenues in
ways that will only deepen the structural flaws in their tax system by
increasing the states reliance on revenue sources that will not grow at the
same pace as the economy, such as excise taxes.

Federal policies are
contributing significantly to the state fiscal crisis by reducing state
revenues and imposing additional costs on states. We estimate that federal
policies are costing states and localities more than $175 billion over the
four-year course of the fiscal crisis (state fiscal years 2002-2005). These
policies include:

Tax cuts. Some of the federal tax cuts enacted since
2001 are reducing state revenues because of linkages between the federal and
state tax codes.

Restrictions on state taxation. For example, the federal
Internet Tax Freedom Act, first enacted in 1998, bars states from taxing the
access fees that people pay for Internet service. In addition, two Supreme
Court cases prevent state and local governments from collecting sales taxes on
most catalog or Internet purchases, even though sales taxes apply when the
very same items are purchased in retail stores. Federal legislation has
recently been introduced to correct this problem but has not garnered
significant support from Congress or the Administration, and its passage is
not expected anytime soon.

Unfunded mandates. In several policy areas, such as
special education and the No Child Left Behind education initiative, the
federal government has placed requirements on state and local governments
without adequately funding them.

Shifting health care costs. For more than a decade, the
cost of health care for low-income elderly and disabled people (in other
words, people who are eligible for both Medicare and Medicaid) has been
shifting from Medicare to Medicaid. A prominent reason is the increasing use
of prescription drugs, which Medicaid covers but Medicare has not. Because
Medicare is fully federally funded, while states pay nearly half of all
Medicaid costs, this shift in costs from Medicare to Medicaid has increased
the financial pressure on states.

The recently enacted Medicare
drug bill will leave states responsible for the bulk of these drug costs even
after the new Medicare drug benefit takes effect. Under the drug bill,
seniors and disabled individuals eligible for both Medicare and Medicaid will
receive drug coverage through Medicare. But, while this will produce
significant savings for state Medicaid programs, states will be required to
return most of these savings to the federal government.

These federal policies have hit
the poorest states especially hard. This is partly because the populations of
these states have the greatest need for government services, and partly
because these states are the least able to raise their own funds to pay for
services.

The $20 billion in fiscal relief
Congress provided in 2003 has helped states cope with the fiscal crisis, but
it pales in comparison to the size of the problem, and the large deficits
faced by the federal government prevent it from doing more. It is worth
noting that a significant part of the projected federal deficits is caused by
the 2001, 2002 and 2003 tax cuts, which primarily benefit households least in
need of assistance. For example, as a result of the tax cuts, households
making over $1 million a year are receiving an average tax cut in 2004 of
$124,000 each, according to the Urban Institute-Brookings Tax Policy Center.

Conclusion

Having closed large budget deficits for three
consecutive years through spending cuts and tax increases (as well as a
variety of budget gimmicks), many states are facing continuing budget problems
in fiscal year 2005 and beyond. The duration of the fiscal crisis means
states are being forced to take increasingly painful steps, such as cutting
back on important services on which many low- and middle-income families rely
 cutting child care and health care programs, raising college tuitions, and
the like.

The federal government could
alleviate the state fiscal crisis by scaling back the costly tax cuts of the
past few years and using the freed-up funds to support more positive policies
toward states. Otherwise, the low- and middle-income families that are
subject to state tax increases and service cuts will, in essence, be paying
for the very generous federal tax cuts for the highest-income Americans.